CoPS/IMPACT Working Paper Number G-242

Title: Adding financial flows to a CGE model of PNG

Authors: Peter Dixon, Maureen Rimmer and Louise Roos

Abstract

Traditionally, CGE models do not include equations modelling the financial sector of a
country. Interest rates are therefore set exogenously and often the nominal exchange rate
is set as the numeraire. Normally, these models would show that tighter monetary policy
(i.e. increase in interest rates) would lead to a fall in investments and a decline in
the domestic price level relative to foreign prices. This causes a real devaluation of
the currency. The fall in domestic prices would be good for the trade balance because the
country becomes more competitive with exports increasing and imports falling. However,
there is another mechanism not captured in these models. If interest rates increase, we
expect that foreigners would want to hold more domestic assets (due to the higher
returns) and domestic agents would want to hold more domestic assets and less foreign
assets. We expect a net inflow of capital and an appreciation of the currency. This
appreciation would then hurt the trade account.

Our task is to develop a financial module and run simulations to investigate the
impact of tighter monetary policy in Papua New Guinea (PNG). The financial module is a
set of equations that are added, as an extension, to an existing comparative-static model
for PNG, see Kauzi (2003). The comparative-static model of PNG is an ORANIG-style model
and includes the core economic equations. In this paper we do not explain the equations
of the core economic module. For a detailed description of the core module, see Dixon et
al. (1982). The financial module is linked to the core CGE model via three conditions.
Firstly, the current account deficit is equal to the net inflow of capital. Secondly, the
government deficit is equal to the new acquisition of domestic bonds. Thirdly, investment
in industry i is set equal to the new acquisition of assets in industry i by agents z.
Once these equations are activated, we endogenously determine the nominal exchange rate,
domestic bond rate and the change in the cost of funds to industries. In this paper we
describe the theory underlying the financial module.

We simulate a 1 per cent increase in the interest rate the BPNG pays to the commercial
banks for holding deposits with the BPNG. The first two simulations with the
comparative-static module are conducted with the financial module inoperative. This means
that the financial module is not linked to the core economic module and that the nominal
exchange rate and rates of interest are set exogenously. We expect the results of these
two simulations to show that tighter monetary policy leads to an improvement in the trade
balance. In simulations 3 we activate the first condition where we set the current
account balance equal to the net capital inflow. This allows us to endogenously determine
the nominal exchange rate. In simulation 4 we activate the second condition where we set
the government deficit equal to the issuing of domestic bonds. We can now endogenously
determine the domestic bond rate. In simulation 5 we activate the final constraint where
we endogenously determine the change in the cost of lending funds to industries. By
activating all the conditions we linked the financial module to the core economic module.
We expect the results of the final three simulations to show that tighter monetary policy
leads to a worsening of the trade balance.